What small business owners need to know about Social Security taxes

Social Security taxes probably aren’t top of mind for many business owners. After all, you’ve got a business to run.

But it’s worth setting aside a few minutes to learn about how Social Security taxes and benefits work — particularly if you’re a small business owner who’s considering switching to an S corporation (or currently own one).  

Let’s start with some background: what Social Security taxes are, how much you have to pay, and what you receive in return. Then, we’ll discuss the tax arrangements for different types of small businesses. Finally, there are a few exemptions worth knowing about, but these won’t apply to most small businesses.  

What are Social Security taxes?

Social Security taxes are a type of federal payroll tax that funds the Social Security system. After paying into the system, retired and disabled workers, along with their family members, and family members of deceased workers can receive a monthly Social Security cash benefit — a check or direct deposit each month.

Social Security taxes are often lumped together with Medicare taxes, which help pay for medical benefits for people who are 65 or older. Together, these are sometimes called Federal Insurance Contributions Act (FICA) taxes. However, we’re going to focus on Social Security taxes in this article.

The Social Security tax rate

Most people work for someone else, and their Social Security taxes are automatically taken out of their paycheck and sent to the Internal Revenue Service (IRS). When this is the case, the tax gets split between the employee and employer, with each party paying half of what’s owed.

As of 2019, the Social Security tax rate is 12.4%. If you’re employed by someone else, you pay 6.2%, and your employer pays 6.2%. However, if you’re self-employed, you have to pay both halves — the full 12.4%.

Whether you’re an employee or self-employed, only the first $132,900 in wages is subject to Social Security taxes each year. (As of 2019; the cut-off point may change each year.)

Determining your Social Security benefits

To qualify to receive Social Security benefits later, you’ll need to accrue at least 40 Social Security “credits.”

You can earn up to four credits each year depending on how much money you make. In 2019, you have to make at least $5,440 to qualify for the full four credits. As a result, you’ll need to work at least 10 years before you qualify for Social Security benefits when you retire.

There are special rules for people with disabilities and surviving family members of someone who passed away which may allow them to collect Social Security without the forty-credit requirement.

Once you qualify, the amount you’ll receive each month depends on:

• Your average monthly income during your 35 best earning years. Only income that’s subject to Social Security taxes counts.
• When you choose to start receiving Social Security benefits. (The earlier you receive them, the less you’ll get each month.)

You can read more in-depth explanations about the calculations in this PDF from the Social Security Administration, and use the quick calculator to estimate how much you’ll receive in Social Security benefits based on different scenarios.

As a small business owner, one of the most important things to keep in mind is that only your income that’s subject to Social Security taxes counts toward these benefits calculations.

Paying Social Security taxes as a sole proprietor or owner of an LLC

How you go about paying Social Security taxes depends on the type of business you run.

If you have either a sole proprietorship, partnership or a limited liability company (LLC) without a corporate election, all your business income gets passed on to your individual tax return. If you made at least $400, you’ll pay Social Security taxes on your business profits when you file your annual tax return.

For self-employed people, the combined Social Security tax (12.4%) and Medicare tax (2.9%) is called the self-employment tax. You can use Schedule SE to calculate how much you owe and must file it along with your tax return.

While you wind up paying 15.3% on your business income, there’s one piece of good news — you can claim a self-employment tax deduction. The deduction is worth half your self-employment tax and can decrease your income taxes; the rationale being that employed people don’t pay income taxes on the employer-paid half of the FICA taxes and you shouldn’t have to either.

Run an S corp? Your owner distributions might be exempt.

Your Social Security tax payments will be different if you run an S corp or LLC taxed as an S corp. (Also if you run a C corp, but that’s not as common for small businesses.)

With an S corp, you have to pay yourself a reasonable salary as an employee of your company. You’ll run payroll to pay your wages, and should withhold the employer and employee payroll taxes (including Social Security taxes) and send those to the IRS.

You won’t be able to claim the self-employment tax deduction because you only paid the employee portion of your FICA taxes (your business paid the employer portion). However, there could be a different benefit to this arrangement.

As the owner of the S corp, the business’ profits will also be passed on to you each year as an “owner distribution.” You don’t have to pay FICA taxes on owner distributions.

So, if your business made $100,000 and you paid yourself a $50,000 salary (which is around what you’d make doing the same work for a different company), the $50,000 you receive as an owner distribution isn’t subject to Social Security or Medicare taxes, saving you $7,650 (15.3% of $50,000).

Note — even if you don’t physically transfer the owner distribution amount from the business’ accounts to your account, you still have to “pass through” the business’ profits to the owners each year. If you decide to leave actual money in the company, perhaps to invest in its growth, you may wind up paying individual income tax on “phantom income.”

The S corp trade-off — lower taxes now or higher benefits later?

Small business owners with an S corp (or LLC taxed as an S corp) have a decision to make. Should you try to keep your salary as low as possible to pay less in FICA taxes now, or should you pay yourself a higher salary to increase your Social Security benefits later?

High-income earners might be able to do both because Social Security taxes only apply to the first $132,900 (in 2019) you make. If you’re a consultant with an S corporation, you might be able to pay yourself a $133,000 salary and still have extra profits to take as an owner distribution. But most small business owners aren’t in this position.

There’s no one-size-fits-all answer. You’ll need to consider how Social Security taxes and benefits will impact your budget today and during retirement, and make a decision based on your personal financial situation.

Certain employees are exempt from paying Social Security taxes

There are a few situations when a person’s wages could be exempt from Social Security taxes. Most small business owners won’t deal with these, but you should still be aware of them:

• Members of certain religious organizations may be exempt if they don’t believe in accepting insurance benefits due to death, disability, old age, or retirement. Qualifying individuals must file Form 4029 with the IRS to be exempt.
• Non-resident aliens, such as a foreign student or professor who is temporarily in the U.S., and employees of a foreign government working in the U.S. (an embassy employee, for example).
• Students who work at the school where they’re studying may also be exempt from paying Social Security taxes on wages from the school. To qualify, the person must be a student who is also working, not a school employee who is also taking classes.

It’s likely you don’t run a university or embassy that employs exempt workers. However, if your employee has an approved Form 4029, your business also doesn’t need to pay Social Security taxes for the employee. See the “instructions to employers” on Form 4029 for information on how to prepare that employee’s W-2.

That wraps up our overview of what you need to about Social Security taxes. Hopefully, you can use this knowledge to help you effectively run and grow your business.

Funding Circle believes informed consumers are better consumers. We strive to provide informative and educational content useful for you and your business. However, please note that tax laws and regulations are complex and subject to change. We strongly recommend consulting your financial or tax professional regarding your specific circumstances.

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